The US faces a fiscal crisis due to the demographic implications of healthcare, social security and public-sector pensions. Over the next decade, as the postwar generation leaves the workforce and begins to draw upon government resources for healthcare and pensions, these budget items will grow rapidly at the federal, state and local level. Without drastic and politically unpalatable reform, these expenses will consume government budgets, leaving no room for government services and activities. The consequences will be high structural deficits, and an exhaustion of national debt capacity.
The run-up to the demographic crisis should have been preceded by a strengthening of the national finances in order to leave some debt capacity for the problem. instead, the country has been running large deficits since as a result of the Great Recession. Federal debt held by the public has grown from $5 trillion in 2007 to $11 trillion today. The ratio of debt held by the public to GDP has risen from below 40% in 2007 to almost 80% today. Without a drastic change in course, the CBO predicts that ten years from now the ratio will climb to 90%, the highest level in postwar history.
Here is the budget arithmetic: GDP has been growing at 4% in nominal terms since the Crash, while federal debt has been growing at 12% over that period (post-crash). The debt is growing 8% faster than GDP, hence the steadily rising Debt/GDP ratio. The deficit represents 30% of federal spending.
Stabilizing (or reversing) the country's debt ratios will require a major reduction in overall spending, entitlement reform, and substantially higher taxes on the middle class. All of these measures are included in Simpson-Bowles, but that plan is an unpopular orphan. Republicans won't discuss taxes or global adventurism, and Democrats won't discuss entitlements or welfare.
Therefore, there will be no fiscal reform, the deficit will remain large (and will grow as Medicare grows), and the fiscal problem will go from being difficult to fix to being beyond fixing. The likelihood of a fix is becoming very low.
Today's children will inherit a country at maximum debt capacity, like Japan is today. While we now enjoy the luxuries of low taxes and high spending, today's children will not. The pleasures that we receive from spending their money will not be commensurate with the financial squeeze that they will face. The ultimate challenge is one of intergenerational morality or rather immorality.
To avert the coming crisis will require two things: (1) immediate fiscal consolidation; and (2) reform of the nation's healthcare and pension systems. The current state of play in Washington indicates that neither is politically possible. There is no political consensus for lower spending, higher taxes and drastic programmatic reforms. The overall consensus is for low taxes, a high level of spending, and unreformed entitlements. Both the Simpson-Bowles and Ryan plans were dead on arrival, and no one wants to discuss them.
The broad-based national consensus against any kind of meaningful fiscal reform is illustrated by the continuing acceptance of large federal deficits despite economic recovery for the past three years. In 2012, federal tax revenues covered only 60% of expenditures, leaving 40% to be borrowed from future taxpayers.
All of the "deficit reduction" measures taken by the administration and Congress since the crash (including the sequester and its "massive cuts") have had little impact on the 10-year fiscal outlook*.
The problem is not only that there is no consensus for reform, but also that the door for reform has almost closed. Too many baby boomers have entered the land of perpetual leisure, and too few have the inclination to die quickly. They are not going to die for decades, they vote, and there will be more of them than there will be working taxpayers. To the retired, Medicare and Social Security are holy sacraments.
I have argued in the past that a principal cause of the fiscal problem is inadequate inflation and inadequate nominal growth, and this remains my view. Higher inflation would reduce the deficit and flatten the trajectory of the debt ratios. It could also be used to partially erase the debt. But inflation these days seems about as popular as Medicare reform. It's not being debated (not even at the FOMC), and the world would probably explode in flames if the CPI ever went above 4%. So that simple solution is off the table, leaving debt accumulation as the likely alternative.
In the context of the looming fiscal crisis, the sequester is small potatoes**. It only affects a small part of the budget in a small way. I happen to like the sequester from a policy perspective, because it cuts defense by a meaningful number, which is good policy if, like me, you are uncomfortable with gold-plated overseas adventurism. Using fiscal policy to "limit the mission" is a good tactic. I also like the cuts to the bloated non-defense budget as well. Any cut is a good cut if your goal is limited government. But the sequester is political theater rather than real fiscal policy. Simpson-Bowles is real policy, as is the Ryan Plan. But they are not being debated.
*The Budget Outlook, CBO, 04 Mar 13.
**The Budget Control Act of 2011
The BCA specifies automatic procedures to reduce both discretionary and mandatory spending during the coming decade. Those automatic reductions will take the form of equal cuts (in dollar terms) in funding for defense and nondefense programs in fiscal years 2013 through 2021. Under the BCA, the automatic enforcement procedures will reduce budgetary resources for defense programs by $492 billion over the 2013-2021 period. By CBO's estimate, the automatic enforcement procedures will reduce discretionary defense resources by about 10% in 2013 and reduce the caps on defense appropriations by lesser amounts thereafter, declining to 8.5% in 2021. By CBO's estimate, the automatic enforcement will reduce nondefense funding (excluding Medicare) by about 8% in 2013 and by declining percentages thereafter, falling to a low of 5.4% in 2021.